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Pay Unchecked

October 2, 2003
Related Topics: Variable Pay, Compensation Design and Communication, Featured Article, Benefits

Human resources didn’t need Bernard Ebbers to create an identity crisis. It already had one. Long before the former WorldCom executive became a symbol of colossal corporate excess, workforce managers were accustomed to being dismissed by critics as spineless wimps who couldn’t stand up to the chief. The Ebbers debacle has only made matters worse. Because of the role that human resources executives played in the alleged $11 billion WorldCom fraud, the entire field of workforce management suddenly has become a target of criticism from many new quarters.

    Ebbers, once a homespun Mississippi high-school coach and motel operator, led his company into bankruptcy, investigators say, using a unique pay and compensation system that made a mockery of conventional human resources standards. Today, Ebbers and five members of his management team face fraud and other criminal charges. Investigators say the downfall of WorldCom also represents a failure by human resources. Given the eye-popping compensation that some CEOs have been receiving in recent years, others say, a WorldCom was inevitable. The moral of this tale: Bad things can happen when human resources rolls over and plays dead.

    "None of us should be shocked," says New York City compensation consultant Alan Johnson. "If you are going to manipulate a company, you have to have control over the motivational system, and compensation is a big part of the motivational system." Looking beyond WorldCom, Johnson says that people managers need to rethink their roles. "In many cases, they have been advocates for management. That is not their job. Their job is to be an advocate for the company and the shareholder. They should have to have a little bit more backbone, a little bit more courage. The job of going forward is not necessarily for the weak of heart. I don’t think people are sympathetic anymore to the view that ‘The boss told me to do it.’ "

    Postmortems on causes of the WorldCom bankruptcy indicate that pay and compensation issues were a root problem. Ebbers dangled the carrot of millions of dollars in bonuses in front of his chief executives in the manner, as one investigator put it, of someone running a private family business. "Indeed, it was executive-compensation decisions more than anything else that seemed to lay the foundations for the fraud that ultimately transpired, and that represented the worst manifestation of WorldCom’s governance failures," says court-appointed corporate monitor Richard C. Breeden in a bankruptcy report filed in federal court. The human resources department stood by and failed "to provide adequate discipline to prevent widespread compensation issues, such as lack of linkage between pay and performance, and poorly designed incentive programs."

Imperial reign
    Passing out huge pay packages allowed Ebbers to enjoy a "nearly imperial reign" at WorldCom, Breeden says, even though the embattled executive "did not appear to possess the experience or training to be remotely qualified for his position." Breeden lays most of the responsibility for the bankruptcy on Ebbers, his chief executives and the company’s board of directors, who have all been replaced. "With compensation in the old WorldCom for the CEO, COO and CFO divorced completely from meaningful performance standards, compensation for these individuals became an exercise in ego gratification and personal greed," Breeden says in the report to U.S. District Judge Jed S. Rakoff.

WorldCom bankruptcy court examiner Dick Thornburgh, a former U.S. attorney general, holds up sales commissions as an example of policies that led to the company’s downfall and also says human resources shares in the blame.

    WorldCom bankruptcy court examiner Dick Thornburgh, a former U.S. attorney general, holds up sales commissions as an example of policies that led to the company’s downfall and also says human resources shares in the blame. "At least until late 2001, the company determined compensation for its sales employees under a dizzying array of commission programs that practically invited, and in fact resulted in, fraud and abuse," Thornburgh says. No one seemed to be paying attention, he says, "including the compensation committee, senior management or the human resources department." Thornburgh is investigating a possible link between extraordinary levels of compensation and the employees’ participation in or knowledge of accounting fraud or other misconduct at the company.

    Ebbers and his attorney, Breeden, Thornburgh and MCI, which is the company that will rise from ashes of WorldCom, did not respond to requests for comment. In previous statements, Ebbers has denied any criminal wrongdoing.

    Until now, human resources has generally stayed out of the public debate that has sparked widespread criticism of lavish pay and compensation for CEOs and other C-level executives, letting company directors, who award the compensation, take the heat. But the costs of the WorldCom fraud are a compelling example of what can happen when human resources fails to exert rational controls over pay, allows itself to get shut out of the process or simply goes AWOL. Tens of thousands of employees lost their jobs at WorldCom. Stock held by company employees that once sold for $64 a share is now worth pennies, wiping out numerous 401(k) retirement accounts. In all, the WorldCom bankruptcy erased $200 billion in shareholder value. Three California public-employee pension funds, led by CalPERS, lost a combined $318.5 million on just one WorldCom bond issue--money invested on behalf of retirees, disabled workers, teachers and other public employees. They are suing the company and its bond underwriters.

    Even before the WorldCom events, extraordinarily high levels of compensation and benefits were being condemned as excessive. Last year, citing a growing disparity between pay for top executives and everyone else, then Federal Reserve Bank president Bill McDonough called for CEOs to take pay cuts, saying that salaries are not only inflated but also morally unjustifiable. Disclosure of a nearly $200 million compensation package for Richard A. Grasso, the top executive of the New York Stock Exchange, so shocked large pension funds and other institutional investors that they pushed for--and got--his resignation. Comparisons have been drawn between $100 million-plus compensation packages for CEOs of failing companies, such as Enron, WorldCom and Global Crossing, and the equally extravagant sums going to heads of companies that are making money but whose shareholders and pension plans are taking a drubbing because of languishing stock prices. General Electric Co., Time Warner Inc. and Tyco International, Ltd., serve as noteworthy examples.

Tighter controls
    Breeden and other critics paint a picture of an extravagant compensation system that is endemic to many large corporations. Symptoms include a weak board of directors and executives who look out for their own interests at the expense of their employees and shareholders. They often focus on short-term earnings to artificially create value for their stock options, rather than the long-term stability of the company. This produces a two-tiered compensation system with a huge gap between people at the top and those at the bottom. Breeden says that WorldCom did not happen in isolation, but was part "of a broader pattern across the industry and large U.S. corporations generally of stratospheric compensation levels."

Many companies, as well as the Securities and Exchange Commission, are moving to tighten up corporate governance to reduce the excesses in the system.

    Many companies, as well as the Securities and Exchange Commission, are moving to tighten up corporate governance to reduce the excesses in the system. Proposals include requirements for more independent directors on corporate boards, rules changes that will give outside investors, like pension funds, a greater say in corporate affairs, and stricter controls over wholesale awards of stock options. Breeden makes 79 recommendations in his 156-page report, and says that full implementation will make MCI a model for corporate governance. Among his proposals is a yearly limit of $15 million on CEO compensation. Under the old rules, Ebbers received $408 million in loans from the company during one 18-month period, and passed out $238 million to senior officers in 2002.

    Breeden breaks new ground with calls for much tighter scrutiny of human resources directors at the company in the future. He recommends that the board’s compensation committee, dominated in the past by Ebbers, appoint three independent members who possess experience with compensation and human resources issues. Under the recommendations, the human resources director would meet with the compensation committee at least twice a year to go over legal-compliance issues and consider employee complaints about compensation. He also wants the human resources director’s job performance to be reviewed at least once a year by the committee.

    The recommendations come at a time when many within corporate America are soul-searching about appropriate levels of compensation for top executives. When it comes to setting salaries for the top brass, workforce executives are often on the sidelines. "What is interesting is that HR executives play such a small role in this," says human resources expert David Lewin, senior associate dean of the MBA program at UCLA’s Anderson School. Lewin compares the compensation systems in many companies to a golf tournament, where the winner might take home $1 million and those farther down receive a tiny fraction of that. He makes the point that in real life, corporate officers make the rules and set the prizes by choosing the boards of directors and outside pay consultants and by controlling board agendas. "When people say pay is out of control, I say quite the opposite: it is under very tight control," Lewin says.

    AFL-CIO official Brandon Rees has a very different perspective. He doesn’t think that involving human resources in setting top compensation levels is the answer to the problem of runaway pay. "It’s a conflict of interest for HR to be advising the board on CEO pay issues, because the HR department reports to the CEO," Rees says. "You just can’t erase that conflict. I would be concerned about any company’s compensation committee using its own human resources department."

    As it stands, CEO compensation often bears little relation to a company’s performance, management, industry standards or recognized formulas. Compensation is bartered and negotiated in secrecy, with numbers emerging only months later in proxy statements. Years are freely tacked on to pension formulas to speed up vesting. Lip service is given to pay being tied to performance, but when a company’s business goes bad and stocks tank, boards have been known to increase cash compensation to keep the CEOs happy. Executives receive lavish "golden hellos" on the way in and golden handshakes on the way out. A study last year by Paul Hodgson of The Corporate Library noted that a $45 million golden hello went to Gary Wendt when he became CEO of Conseco, Inc., an insurance company. His signing bonus is an extreme example of the fact that money can’t buy success. Wendt resigned in 2002, the company went into bankruptcy and its stock for a time was virtually worthless, but now is recovering.

Sweet deals attacked
    As criticism of CEO compensation escalates, executives like Jeffrey Immelt, CEO and chairman of the board at General Electric Co., are finding themselves targets. No sooner had Immelt gotten the seat warm as CEO than the $22.9 million in cash, stock and options he earned during 2002 was being questioned. The man he replaced, Jack Welch, had become one of the richest individuals in America while at GE’s helm and retired with a $100 million-plus platinum handshake package. Now, here was Immelt, pulling down his own princely sum, even as GE stock languished at prices about 20 percent below what it had been worth when he took the job two years earlier. That was good enough for Immelt to make the AFL-CIO’s Executive Paywatch list, which profiles a cluster of corporations that have questionable investment and pension practices.

    In Immelt’s case, the union says it was alarmed at the disparity between pensions for General Electric’s top executives and those for regular employees. GE has a two-tier retirement system--one for senior executives and one that is less generous and more restrictive for lower-level employees, the union says. Another issue is the depressed stock price, down to nearly half of its value during Welch’s last year, because the GE employees’ 401(k) plan is heavily invested in company stock. Heat from shareholders and the concern of Immelt and the GE board are producing changes in compensation rules.

    Gary Sheffer, a spokesman for GE, defends Immelt’s salary: "The board determined that that level of pay was appropriate for someone who leads a global organization of 313,000 employees and generates $140 billion plus in revenues." Sheffer also says that under new corporate-governance rules, Immelt has more restrictive guidelines covering stock options. Last year, he put 75 percent of his cash compensation back into company stock and pledged to hold the stock as long as he is chairman. The value of future stock grants will also be based in part on GE’s performance in the stock market.

    Earlier this year, BusinessWeek, which publishes an annual list of America’s highest-paid executives, reported a decline in the $100-million compensation club for 2002. In 2001, seven executives made more than $100 million, led by Oracle Corp. CEO Lawrence J. Ellison, $706.1 million; Jozef Straus, chief of JDS Uniphase, $150.8 million; Howard Solomon, Forest Laboratories, $148.5 million and Richard Fairbank, Capital One Financial, $142.2 million. In 2002, it was a smaller group: Alfred Lerner of MBNA took in nearly $195 million, while Jeffrey Barbakow, chief executive officer of Tenet Healthcare received $116.6 million. In 2002, BusinessWeek reported, pay packages declined 33 percent to an average of $7.4 million.

Tip-off to other problems
    Critics say that lavish compensation programs, because they often are tied to loose control by corporate boards, can be a tip-off to much bigger problems, as was the case with WorldCom, Tyco and Enron. "Compensation tends to be a fairly useful window that gives you a lot of clues about how boards are operating and aligning their interests," says Ted White, director of the corporate-governance program at CalPERS, a public-employee pension system with assets of $149 billion. Companies that experience the largest layoffs, report the most underfunded pension funds and receive the biggest tax breaks also are among those paying the highest rates of executive compensation, according to a study published in August by the Institute for Policy Studies. The study also notes that the disparity between pay at the top and earnings of production workers remained well above historic levels. In 1982, the CEO pay gap was 42 to 1, whereas in 2002 it stood at 282 to 1. If the average annual pay of production workers had risen at the same rate since 1990 as it has for CEOs, their 2002 annual earnings would have been $68,057 instead of $26,267, the study says.

    Bruce Ellig, retired corporate vice president of employee resources at Pfizer, Inc., and long active in the Society for Human Resource Management, says that human resources managers "could make a very big contribution" in all this. But he adds that many human resources managers are way behind, and must become broadly knowledgeable in accounting and finance, Securities and Exchange Commission requirements and tax laws before they can bust into the top corporate tier where CEO compensation issues are decided. "If they had HR people who were smart enough and good enough to handle touchy issues, I don’t think a lot of this would have happened," says Ellig, author ofThe Complete Guide to Executive Compensation.

    Other say changes are occurring already. Tony Lee, editor of, says human resources professionals have taken great strides in playing a bigger role. "Their voice is being heard more than in the past," he says.

    With so much at stake, consultant Alan Johnson says, human resources executives ought to be far more involved in the salary process than they are now. "They should play a bigger role absolutely than they have played to date," he says. "A lot of people didn’t distinguish themselves in the WorldCom failure. Human resources was certainly part of that. We have been too forgiving of people with too little courage."

Workforce Management, October 2003, p. 28-33 -- Subscribe Now!

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